Free Lunches

“The state is the great fictitious entity by which everyone seeks to live at the expense of everyone else.”

-Frédéric Bastiat

In Frédéric Bastiat’s 1950 essay, “That Which Is Seen and That Which Is Unseen”, he describes the impact of opportunity costs on economic activity. In his essay, a small boy breaks a window in a store. The glazier comes to repair the window and is paid six francs for the job. Some observers would suggest this is a positive economic event as it increases the money circulating in the community.

There is, of course, no free lunch. In the case of Bastiat’s essay, the unintended consequence is that the store owner with the broken window must pay for the repair of the window. In using six francs to pay for the repair of the window, the shopkeeper no longer has six francs to expand his inventory, advertise for the shop, or purchase personal goods. In effect, the transaction has two sides and it is not even certain to be a zero sum transaction, especially if the glazier does not spend his incremental six francs within the local community.

In modern economic theory, the key current debate relates to the role of the government in transactions. The Allowance Rebate System (more commonly known as Cash for Clunkers) program is a prime example of this dilemma. Under this program, car buyers were incentivized to purchase new cars by being given a $4,500 rebate for their old cars, which then had to be scrapped. Practically, this was a transfer of money from tax payers to car buyers. In the short term, new car sales skyrocketed. Meanwhile, older vehicles, which admittedly produced more pollution, were taken out of the national car population.

Akin to Bastiat’s essay, the question in the case of Cash for Clunkers Car is whether destroying an otherwise productive asset, such as a working car, actually benefits the economy. In looking at some key results of Cash for Clunkers, the implication is at best inconclusive. Specifically,

The program led to market share gains for Japanese and Korean car manufacturers at the expense of U.S. manufacturers. (Incidentally, the equivalent Japanese program did not include U.S. produced cars.);

A study by the University of Delaware concluded that for each vehicle trade, the net cost was $2,000, with total costs exceeding benefits by $1.4 billion; and

A study by economists Atif Mian and Amir Sufi indicated that the 360,000 additional purchases in July and August 2009 were pull forwards that were completely reversed by March 2010.

So, once again, no free lunch.

On the back of rumors of an IMF bailout of Italy, global equity markets rallied in a big way yesterday. Not surprisingly, the Italian equity market was one of the global leaders yesterday up an impressive +4.6%. While we would suggest this was more of a short squeeze than anything, there is perhaps a fundamental case to be made if the IMF rumors finally come to fruition . . . or is there?

Our trusty research intern Josefine Allain pulled together some detail around the rumored IMF plan. According to the rumors, the IMF would provide €400-€600B to Italy at a rate of 4-5%, which would allow Italy up to 18-months to implement reforms without having to refinance.

Setting aside the fact that the IMF denied it is in discussions with Italy, the plan has two main issues. First, the IMF only has $285 billion currently available. Second, an expansion of the IMF, or an explicit Italian bailout fund, would require a substantial contribution from the United States (likely more than $100 billion). Clearly, given the current political environment in D.C. and on the back of another tacit U.S. debt downgrade this morning from Fitch, the likelihood of the United States stepping up to bailout out Italy is slim to none, absent a global financial crisis.

Indeed, European credit markets continue to signal that no free lunch from either the ECB or IMF is imminent. Specifically, the Italians “successfully” sold €7.5 billion of bonds this morning versus a maximum target of €8.0 billion. The 3-year yield was 7.89% versus 4.93% on October 28thand the 10-year average yield was 7.56% versus 6.06% on October 28th. Success is a relative term.

In the Chart of the Day today, we’ve highlighted the Euribor-OIS 3-month spread, which measures the spread between what banks charge each other for an overnight loan of their excess reserves versus what they could earn by lending it risk free to the central bank. The key take away is simply that risk, not surprisingly, has accelerated dramatically in the last three months in the European banking system. In early July this spread was less than 0.20 and it is now at 0.94. No free lunch there, to be sure.

This afternoon Keith and I are going to take a much needed break from the grind and go across the street to play a quick game of hockey at Yale’s Ingalls Rink. Ironically, it will cost us $10 each, so there isn’t even free lunch time hockey.

Keep your head up and stick on the ice,

Daryl G. Jones

Director of Research

Share

Print

11/29/11 07:46 AM EST

THE HEDGEYE DAILY OUTLOOK

THE HEDGEYE DAILY OUTLOOK

TODAY’S S&P 500 SET-UP - November 29, 2011

We are once again seeing the “fun and games with month-end markups” on no volume. Buyers beware of the US economic data Wednesday-Friday - expectations are too high. If you want to get bulled up on something into the start of the new month, go with US Dollar (UUP) or Long-Bond (TLT) on red today.

As we look at today’s set up for the S&P 500, the range is 32 points or -1.81% downside to 1171 and 0.88% upside to 1203.

SECTOR AND GLOBAL PERFORMANCE

EQUITY SENTIMENT:

ADVANCE/DECLINE LINE: +2044 (+2429)

VOLUME: NYSE 958.60 (+116.99%)

VIX: +33.13 -6.79% YTD PERFORMANCE: +81.01%

SPX PUT/CALL RATIO: 2.71 from 1.88 (+44.21%)

CREDIT/ECONOMIC MARKET LOOK:

TED SPREAD: 50.66

3-MONTH T-BILL YIELD: 0.03%

10-Year: 1.97 from 1.97

YIELD CURVE: 1.71 from 1.69

MACRO DATA POINTS (Bloomberg Estimates):

7:45am/8:55am: ICSC/Redbook comp sales

9am: S&P Case-Shiller, est. -.10% M/M, -3% Y/y

10am: Consumer Confidence, est. 44.0 (prior 39.8)

10am: Home price index (prior -0.6%)

11:30am: Fed’s Yellen speaks on global recovery in SF

11:30am: U.S. to sell $35b 4-wk bills

12:15pm: Fed’s Raskin moderates panels in SF

12:27pm: Fed’s Lockhart to speak on U.S. economy in Atlanta

12:30pm: IMF publishes paper on capital flows

4:30pm: Fed’s Williams speaks to reporters in SF

4:30pm: API inventories

7:30pm: ECB’s Stark speaks in Dallas

8pm: Fed’s Kocherlakota speaks to reporters in Calif.

WHAT TO WATCH:

Facebook said to consider raising ~$10b in IPO that would value it at more than $100b

EURO – another day, another hope that a USD selloff and a Euro rally is real. Unfortunately, the math is getting in the way of that; EUR/USD has an important short-term line of resistance that it’s been fighting for 48 hrs at 1.34; ultimately, the bigger lines that matter are TRADE and TAIL resistance of 1.36 and 1.40, respectively.

EUROPEAN MARKETS

ITALY - On its shortest duration (the 2014 bonds) Italy Sells another €3.5B at 7.89%; a few months ago 6% was the "critical" line, then 7%, now I guess its 8%? C’mon. Let’s get as serious as Spread Risk is telling you to be here – Italian stocks are barely up this morning – and more importantly, down -37% since FEB (crashing) – no support for the MIB Index to 13,422

INDIA – stocks decided a 1-day rally to a lower-high was enough. Inflation isn’t going away on EUR/USD up days because Oil prices aren’t going down (Brent $110/barrel last), and Indian stocks don’t like sticky stagflation – down -1% overnight, taking the Sensex to 16,002 (down -22% for 2011 YTD).

Saaanta Claus Is Coming to Town: TLT Trade Update

Conclusion: We are firm believers in the year-end Santa Claus rally – in the long-end of the U.S. Treasury bond market.

Earlier today, Keith reopened a long position in the iShares Barclays 20+ Year Treasury Bond Fund (TLT) in our Virtual Portfolio. We’ve been trading around the volatility in long-term U.S. Treasury bonds with a bullish bias since 2Q and we continue to have conviction in our belief that U.S. growth is slowing from a cyclical perspective and structurally impaired from a secular perspective absent a shift towards strong dollar policy in D.C. This is a position that has worked throughout much of 2011 and our research suggests it will continue to work over the intermediate term.

Today, our quantitatively-driven risk management process signaled to us that, while consensus remains hopeful for a year-end Santa Claus rally in equities (SENTIMENT), domestic and international economic growth is still slowing from an intermediate-term TREND perspective (DATA/CATALYSTS). But don’t just take our word for it:

“Rather than saying interest rates are too low, investors should be more concerned about what low rates are telling them about economic growth and expected returns on risky assets.”

- Robert Mead, Portfolio Manager at PIMCO

Treasuries are “expensive” for a reason and a great many stocks appear “cheap” for similar reasons. Moreover, as Keith penned in his Early Look this morning, Dynamic Risk Management (i.e. fluid asset allocation and trading the ranges) has been the winning strategy in 2011. Buy & hold isn’t the best short-to-intermediate term P&L risk management strategy with a VIX > 30 (yes, performance pressures do exist in our business). Eventually, the time will come to get really long of U.S. equities – our models are merely suggesting that time is not now.

Darius Dale

Analyst

Share

Print

11/28/11 04:08 PM EST

Weekly Asia Risk Monitor: The Many Faces of King Dollar

Conclusion: The concurrent events and associated risks of King Dollar strength continue to be showcased across Asian financial markets and economic data.

PRICES RULE

Inclusive of today’s global short squeeze, Asian equities had another soft week (11/21-11/28), closing down nearly a full percent on a median basis. The spread between the best performer (Thailand; +2%) and the worst performer (Australia; -2.5%) was a healthy 450bps.

Asian currency markets were generally flat on the week, closing down -0.1% on a median basis. Gains were led by the Queen’s currencies (Aussie and Kiwi dollars), which closed up +1.2% and +1.3% wk/wk vs. the USD, respectively. The Japanese yen closed down -1.4% wk/wk vs. the USD and JPY weakness slightly lead today’s rally in global beta.

Asian 5yr CDS had a generally mixed week, highlighted by the +15bps widening of Japanese swaps on the rumors of an eventual S&P downgrade.

CHARTS OF THE WEEK

THE LEAST YOU NEED TO KNOW

If you didn’t get a chance to review our 11/22 research note titled “Asia Isn’t Buying Into Santa Claus”, please email us for copies. The analysis below picks up where that piece left off.

Growth Slowing:

HSBC’s preliminary manufacturing PMI for China (85-90% of responses) ticked down to 48 in Nov vs. a final reading of 51 in the month prior. The final HSBC and official CFLP readings are due out this Wednesday evening and could shock global macro markets if they are in-line with the aforementioned sneak peek.

Japanese small business confidence ticked down in Nov to 45.8 vs. 46.4 prior.

The Reserve Bank of India cut its domestic growth forecast for the current fiscal year to +7.6% YoY from +8% prior. While it’s easy to say they were a step closer to easing as a result, India’s domestic inflation situation is set to remain among the least accommodative in the world over the next 3-6 months based on our models and imprudent monetary policy (i.e. implementing QE with WPI > +9.5%). “Inflation is a regressive tax that hurts the poor the most in a country like India where food is a large share in the consumption basket,” per RBI Governor Duvvuri Subbarao. Moreover, the FX depreciation detailed below suggests he might be forced to hike rates again and risk slowing Indian economic growth incrementally from here.

On the heels of slowing commercial sales and industrial production growth (to +1.8% YoY and +1.4%, respectively – the latter at a 26-month low), Taiwan’s statistics bureau cut its 2011 and 2012 growth forecasts to +4.51% and +4.19% (from prior estimates of +4.56% and +4.38%, respectively).

At face value, Singapore’s Oct industrial production growth looked quite healthy (+24.4% YoY vs. +11.3% prior). Peeling back the curtain, however, we see that the pickup in growth was entirely driven by pharmaceutical output (+117.5% YoY), while electronics production (iPad and Kindle parts, etc.) slumped -20% YoY.

Though largely a function of nationwide flooding which shuttered factories and caused capacity utilization to tick down to an all-time low of 46.4% in Oct, Thailand’s manufacturing production growth tanked in Oct to -35.8% YoY vs. -0.3% prior. Hard disk drive production (of which Thailand is the world’s #1 supplier) fell -52.4% YoY and electronics parts fell -45.5%. Thailand’s Office of Industrial Economics added that it may take 1-2 months before plants can resume normal operations after the flood waters recede.

Sticky Stagflation:

The PBOC said in a statement last week that it will continue to implement “prudent” monetary policy. Sticky inflation that remains well above target continues to slow China’s monetary easing process, despite their pledge to promote “reasonable growth” in credit and money supply. While the PBOC will do what it can in the interim (last week it cut RRRs in Zhejiang and 20 rural credit cooperatives), we remain of the view that substantial monetary easing in China is 1-2 quarters out absent a strong deflationary shock (i.e. a dramatic, expedited breakout in King Dollar).

Chinese industrial profit growth slowed in October to +12.5% YoY, which was less than half the YTD run-rate of +27% (Jan-Sep). The impact(s) of slowing growth on top line trends, inflationary margin compression, and credit tightening continues to weigh on industrial activity in China.

Hong Kong CPI held at +5.8% YoY in Oct.

King Dollar:

The Chinese yuan continues to gradually weaken, closing down -0.3% wk/wk vs. the USD and is now trading at a ~30bps discount to 1yr non-deliverable forward rates. Expectations of yuan weakness continues to be a headwind for the dim sum bond market as investors demand more interest rate return to offset less FX appreciation; average yields rose +32bps in the month-to-date and +197bps over the last six months. We saw this play out via growth in offshore yuan deposits in Hong Kong, which slowed in 3Q to +69.6 billion QoQ vs. +102.2B in 2Q.

Japanese CPI slowed in Oct to -0.2% YoY from 0.0% prior; core CPI slowed to a -1% YoY from -0.4% prior. This easing of inflation, particularly on the core side, is one more supportive data point for additional easing out of the Bank of Japan – which just recently shifted its tone on the margin towards supporting incremental accommodation. Per BOJ Governor Masaaki Shirakawa: “In the current time of high uncertainty regarding the future prospects of overseas economies, due attention is necessary to the risk that the yen’s appreciation will dampen future growth… This is the very reason that the bank has embarked on monetary easing measures twice since this summer.” Speaking at an anti-strong yen groupthink convention in Nagoya today, this the third time over the last few weeks the governor has spoken out regarding the threat Europe’s sovereign debt crisis poses to the Japanese economy. His comments were delivered to us this morning concurrently with data that shows the BOJ capital adequacy ratio hitting a 32yr-low of 7.23% after suffering a $1.2 billion loss from its asset-purchase program in the six months through September.

Last week, India’s rupee touched an all-time low of 52.375 per USD, prompting the Reserve Bank of India to pledge managing the associated FX volatility via intervention in the spot market. On the flip side, R. Gopalan, secretary of economic affairs at the finance ministry, suggested last week that the RBI’s ability to aggressively stem the rupee’s slide is limited because of the tightness of interbank liquidity and the likelihood that USD-selling would lead to an even higher call-money rate (30-day average of 8.49% is a near 3yr-high). Another sign of interbank illiquidity in India: banks borrowed an average of 1.13 trillion rupees per day from the RBI’s overnight lending facility over the last week – the highest rolling 7-day average since January. The rupee weakness is being fueled by a foreign investors dumping of Indian assets (bond holdings down -$213 million wk/wk; equity holdings down -$1.8 billion since July) and a near closure of India’s dollar debt and international syndicated loan markets (the latter down -87% MoM in Oct in terms of issuance). In recent weeks, the RBI and central gov’t have implemented new rules designed to spur dollar inflows, including increasing the cap on foreign investor rupee debt ownership by a total of +$10 billion, loosening rules for overseas corporate borrowing, and removing a $100 million limit on corporate FX sales via currency swaps . King Dollar manifests itself in many ways across the Global Macro landscape.

Jesse Wang, executive vice president of China Investment Corp, the nation’s sovereign wealth fund, recent comments affirm our conviction in the view that China will not be a source of dumb, unlimited capital to finance the Eurozone bailout, but rather a source of smart money looking for attractive investment opportunities in distressed real assets: “The fund wouldn’t be the main channel if China helps tackle the sovereign debt crisis... However, if during such a process there are good investment opportunities in Europe and if CIC’s investment helped the destination company or country to recover and developed the economy, that would be indirect support.” Commerce Minister Chen Deming shared those views in his recent remarks: “While China has always been supportive of Europe’s rescue efforts, these will mainly depend on the euro zone itself… China will definitely be a part of any help offered by the global community… We are willing to further reform and further open our market, but other economies must be more open to us in return.”

Analyzing commentary out of China and Australia, it appears the global community is growing increasingly tired of Europe’s inaction on adequately addressing its sovereign debt crisis. Per China’s Commerce Minister Chen Deming: “So far we have yet to see a step towards success… We have only seen a reshuffling of leaders in some European countries.” Per Australian Treasurer Wayne Swan: “EU politicians have been frustratingly slow in tackling the region’s sovereign-debt crisis that has dragged on global economic growth and cut Australian government revenue, causing asset prices to fall and households to spend less… Europe needs to understand that financial markets don’t work on political timelines, and they are already a long way behind the curve. The global economy has already paid a very high price for the failure of Europe to get its house in order.”

Japanese asset managers are blowing out of European sovereign debt (including German and French paper) in the year-to-date, opting for U.K. gilts instead – +$19.1 billion in direct purchases and another +$37.4 billion channeled through the Cayman Islands.

Philippines real GDP growth accelerated in 3Q11 to +3.2% YoY – after a downward revision to the 2Q report to +3.1% from +3.4%. Growth still slowed outright on a QoQ basis, which may add to pressure on Bangko Sentral ng Pilipinas to ease monetary policy later this week.

Other:

A read-through on the weakness of China’s property market (absent more-reliable official price data): 80% of construction companies said developers were behind on payments, per a recent Credit Suisse survey.

Standard & Poor’s said the leadership in Japan, led by recently-elected Prime Minister Yoshihiko Noda, hasn’t made enough progress in tackling the nation’s public debt burden. “Japan’s finances are getting worse and worse every day, every second,” according to Takahira Ogawa, director of sovereign ratings at S&P in Singapore. “[Consensus] may be right in saying that we’re closer to a downgrade. But the deterioration has been gradual so far, and it’s not like we’re going to move today.” Be it S&P, Fitch, or Moody’s, which all have Japan’s long-term, local currency sovereign debt rated at some form of AA-, the next downgrade of Japan is likely to trigger capital raises across Japan’s banking system to the tune of $75-81 billion based on Basel II requirements and Hedgeye calculations. Perhaps that’s yet another reason why the Topix Bank Index is trading a mere +1.6% off its 20yr-low (established on Friday).

Darius Dale

Analyst

<chart4>

<chart5>

<chart6>

Share

Print

11/28/11 03:28 PM EST

FL: We’re Getting More Cautious…

Conclusion: There’s so much more to this story than the NBA. While there’s still much to like, the negative fundamental factors are lingering that the consensus might be missing.

It’s time for a serious update on Foot Locker. With two upgrades today – largely timed around the mitigated risk of a hit from the NBA strike – we think that people are glossing over some larger issues. Some are bullish, but for the first time in two-years, some bearish factors are starting to enter the equation. From a TRADE perspective (30-days or less), this name is still in a bullish formation and is one of the more attractive retailers based on Keith’s models. But as we head into 2012 and look at how the fundamentals are stacking up, our bull-case is no longer a slam dunk by any means.

About the NBA strike… Ok, the risk is gone. I get it. But was there really any implied risk in FL from a strike in the first place? There’s a lot of noise week to week, but my answer is that – in aggregate -- the market has had this about right all along, and there really shouldn’t be a go-forward adjustment.

The timeline is important for a couple of reasons…

The lockout started on July 1, but there was still perceived to be ample time to negotiate a deal. The stocks did nothing. But as talks cooled throughout July, FL underperformed the market by about 8%, and the broader retail space (MVRX) by 12%.

Let’s not forget that the market simply melted down in August. On a relative basis, FL was a great place to be. By the time September 30 rolled around, FL had largely recouped all its losses (again, relative to the market and retail).

Once the NBA cancelled the first two weeks of the season in October, the stock stalled, but only gave up 2-3%.

But near the end of October, the market looked into the quarter, the health of its inventories, comp sales, ability to side-step basketball risk, and it was subsequently one of the better performing names in retail.

Now we’re at a point where it has come full circle, and then some. It outperformed all relevant peers, comps, and broader benchmarks over the lockout period. Ironically, the only name that has performed better is Nike, which has greater basketball exposure. Yes, FL has printed good numbers in the interim, but at a decelerating rate relative to what we’ve seen in the past.

As much as Ken Hicks is running such a good ship and is rethinking the model, the fact is that the numbers simply get tough. We’ve had 10% comps over the past year, 40% EBIT growth, and seven consecutive quarters of improvement in the sales/inventory spread. It’s worth noting that over this precise seven quarter period, FL has beaten every quarter by a weighted average of 32%.

So what now? Product costs from the Nike’s of the world (even if only Nike) are being passed through to a far greater extent, and anemic levels of product in broader athletic channels will be refilled (note order books for all brands). FL will have a harder time keeping inventories in check, which definitely jeopardizes (peak) margins. Also, let’s not forget Europe, which is about 25% of sales, and is about 33% of EBIT. These stores are more productive and profitable than US counterparts. There’s a bit of a tug of war on the P&L between comp and SG&A, but net/net, the Euro had been a tailwind for the past 3-quarters. Economies aside…it becomes a headwind in 1Q13 (Feb 2012). The Olympics in London might be a jolt, but it will need to be a big one to offset the impact of a weaker pan-European consumer.

But might the company be a victim of his own success? Hicks delivered on his 5-year plan 3-years ahead of schedule. That in itself is so impressive – as has been the reward. Hicks made $2.475mm in cash last year ($1.1mm base with 125% target bonus – which he hit). That’s in-line with peers. The real kicker for him is in his incentive comp. He has 500,000 shares of restricted stock, and 900,000 outstanding options with strike prices between $10.1 and $15.1. The value of his vested equity at today’s $23 price is $8.6mm. The remainder vests by March 2013, and is worth approximately $21mm at today’s price. Every $1 fluctuation in FL’s price equals about a $1.2mm change in Mr. Hicks’ net worth. While he is a very accomplished retail executive, I’m going to assume that with a history at JC Penney and Payless, this kind of wealth creation is a huge deal for him, and something that he won’t let evaporate. This story is unlikely to crumble over the next 18 months when the rest of the options vest and the restricted stock balloon is up. But a risk that can’t be ignored is that these numbers are just so big and comfortable, and that he becomes complacent running a slow moving company in a business that is sub-par at best. In other words, that he becomes Matt Serra. Not likely, but we need to monitor it.

They’re hosting an analyst meeting in March to outline the new strategic plan. It might be foolish to bet against them. I don’t like betting against good management teams (it’s a long time since I’ve said that about FL). But numbers don’t lie, and the order of magnitude of additional changes will be difficult to engineer. Sales per square foot should break $400 this year, and prior peak flirted with $362. Margins are peak, and let’s not forget that this is a zero-square-footage-growth retailer with 33% exposure to Europe.

If the consensus numbers are right, and we actually think that they’re within a nickel of reality, then we’re looking at 14% EPS growth for next FY13, which is a sharp deceleration from the 61% FL is on track to print this year. The today’s two upgrades, there are officially no sells on the stock, and short interest remains relatively low at 6.1% of the float.

Brian McGough

Managing Director

Share

Print

get free cartoon of the day!

Start receiving Hedgeye's Cartoon of the Day, an exclusive and humourous take on the market and the economy, delivered every morning to your inbox

By joining our email marketing list you agree to receive marketing emails from Hedgeye. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.

Thank You!

Your request has been received

You have been added to our list and will receive an email shortly.

If you do not receive an email, please check your spam filter, and then email
support@hedgeye.com.
By joining our email marketing list you agree to receive emails from Hedgeye. This is a distinct and separate service form any of our paid service products. You may unsubscribe at any time by clicking the unsubscribe link in one of the emails.